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This Emerging Fiscal Cliff Deal Could Push the Economy Into Recession

Yahoo! Finance

The Exchange•December 19, 2012

By Peter Morici

Washington has always made lots of things—bureaucratic regulations and hot air to name two—and it even prints money that instigates inflation. Now in the names of fairness and fiscal responsibility, President Obama and Speaker Boehner are cooking up a deal to avert the fiscal cliff that could easily thrust the economy into a deep recession.

Taxes are going up.

Just about everyone agrees the two percentage point temporary reduction in the payroll taxes will lapse—it is too much of a drain on the solvency of Social Security. That will raise about $125 billion in revenue for 2013.

It is now apparent the Bush era income tax reductions for many wealthy families will not be extended. Mr. Obama is now willing to settle for raising rates on families earning over $400,000, whereas Mr. Boehner wants to set the threshold at $1 million. The cutoff that will likely emerge is about $500,000 and would generate another $50 billion a year in income taxes.

Dangerous Compromises

The Administration would also like to limit the value of itemized deductions and other tax breaks, including the tax-free status of municipal bonds. Mr. Boehner is inclined to go along, and if he accepts the President’s framework, it should generate another $50 billion in income taxes.

Republicans want spending cuts that at least match tax increases. The question is what tax increases will they get matched—$100 billion in additional income taxes or that sum plus the additional $125 billion obtained by letting the payroll tax holiday lapse?

Given how stubbornly the President defends the rapid growth in entitlements and his desire to extend long-term unemployment benefits, the likely target for Republicans is $100 billion in cuts from permanent reductions in entitlements and some trimming in other domestic areas and defense.

The President also wants some jobs creating temporary infrastructure spending in the range of $50 billion.

Get Ready for GDP Growth to Fall

Hence, overall taxes will rise about $225 billion and spending will be cut by about $75 billion, subtracting at least $300 billion from GDP in 2013—or nearly 2 percent, and owing to the ripple effects through the economy, about $450 billion from GDP in 2014.

The economy was growing at two percent until nervousness about the fiscal cliff recently dampened business spending and hiring.

Though some economists were optimistic that the housing recovery and stronger auto sales could spell better times, with such a new large drag on the economy, GDP growth in 2013 and 2014 will likely be below 2 percent for the next several quarters.

At that pace, businesses can easily handle most new demand by increasing productivity, and even trim payrolls to further boost profits. Hence, growth below 2 percent for several quarters could easily instigate a negative feedback cycle—layoffs cut household income and consumer spending, and in turn, the latter begets more layoffs.

U.S. the New Europe?

What is going on in Washington these final weeks before the New Year is the kind of fiscal fundamentalism that is making Greece, Italy and Spain economic train wrecks.

With unemployment so high, real wages falling and so many folks working part time for lack of full time work, the unemployment rate could easily surge into the teens, and no amount of stimulus spending could bring it back.

Clearly, Messrs. Obama and Boehner know a lot about getting elected but on economics they are spread thin. Like the sorcerer’s apprentice, they are courting disaster.

Peter Morici is an economist and professor at the Smith School of Business, University of Maryland, and widely published columnist.